Unemployment in Spain has reached 17.4 percent, according to figures released April 24 by the National Statistics Institute. Even without the global recession, Spainís economy likely would be going through a rough patch now due to the countryís overheated housing market; with the recession, it is also suffering from a banking crisis and an industrial slump.
Spainís unemployment rate rose from 13.9 percent in the fourth quarter of 2008 to 17.4 percent in the first quarter of 2009, increasing the ranks of the unemployed to more than 4 million, according to National Statistics Institute (INE) figures released on April 24. Spanish Economy Minister Elena Salgado said that the first quarter of 2009 will be the worst in terms of increasing unemployment. The International Monetary Fund (IMF) predicts that unemployment in Spain will reach 17.7 percent in 2009 and 19.3 percent in 2010, but the INE figures seem to indicate that unemployment could exceed 20 percent by the end of 2009.
Of all the European countries, Spain has in many ways been one of the most gravely affected by the global economic crisis. Even without the global recession, Spain would most likely be undergoing a correction this year due to its extremely overheated housing market. But it is facing a severe housing market correction, an industrial slump, and a banking crisis caused by the housing correction and the recessionís overall effects ó simultaneously. These three ingredients make for one bitter stew.
As the first large Western European country to be severely tested by the crisis, Spain can serve as a case study for the other European economies, foreshadowing the troubled road ahead for much of Western Europe.
The Beginning: The Euro and the Housing Boom
Spainís trouble has its origins in one of the most fundamental challenges facing the eurozone: how to devise a single monetary policy to harmonize the very different economies within the (now) 16-country currency bloc. Initially, Spain benefited greatly from the policies set by the European Central Bank (ECB); the euro interest rate it enjoyed in 1999 when it entered the eurozone was lower than anything the Spanish economy had been able to attain on its own.
Backed by the strong and stable German economy, the euro interest rate allowed consumers in countries such as Italy, Spain and Ireland ó normally at pains to afford credit due to high interest rates ó to spend like never before. This fueled an unprecedented demand for consumer goods (such as cars, kitchen appliances, etc.) and houses bought on credit that propelled the Spanish housing boom, which led to booms in the construction and mortgage lending industries.
Without control over interest rates, however, Madrid was unable to rein in the housing boom on its own, and in many ways Spainís policies only exacerbated the crisis. The end result was one of the most overheated housing markets in recent European history. In 2006, for example, there were more than 700,000 new homes built in Spain ó more than the combined totals of Germany, France and the United Kingdom. (The United Kingdom was itself experiencing a housing boom at the time, making the Spanish expansion in housing all the more impressive.) At one point, investments in the Spanish housing sector made up almost 10 percent of the entire Spanish gross domestic product (GDP). Spanish mortgage lenders were offering loans very liberally ó particularly to young Latin American migrants with no prior credit history, as part of government policies to speed up integration and assimilation ó and were often giving loans of more than 100 percent of a propertyís total value. Simply put, the excesses of the Spanish housing boom put the U.S. subprime debacle to shame.
The U.S. housing boom started under similar circumstances, although the U.S. interest rate was cut due to the effects of the 2001-2002 recession and not because of the introduction of a new currency. The subsequent housing booms in Southern California and Las Vegas are comparable to what happened throughout Spain: Low interest rates fed a frenzy of demand, both by residents and outside investors, pushing up housing prices and luring consumers to overleverage themselves in purchasing overvalued homes they had no business owning in the first place. The U.S. and Spanish housing booms were both characterized by liberal bank/mortgage institution lending and risky mortgage products, with both countries falling in love with variable interest rates in particular.
For Spain (as for the United States), the party was going to have to end at some point. While lending practices created a glut of new homeowners who should never have been allowed to own homes, the construction boom created a glut of properties without buyers. Therefore, even before the global financial crisis manifested itself in earnest in September 2008, Spain was in trouble. The 2.2 percent of GDP budget surplus of 2007 ó at the time the second-largest surplus in the eurozone ó had evaporated into a 3.8 percent deficit in 2008. This was mostly due to a combination of real estate development firm failures (such as real estate giant Martinsa-Fadesaís bankruptcy in July 2008) and the collapse of the construction industry. Housing prices declined a stunning 26 percent in the month of December 2008 alone.
Madrid Takes Charge with Stimulus Spending
With a significant proportion of Spainís labor pool employed by construction, unemployment was already on the way up prior to the economic crisis. Employment in the construction industry suffered an 8 percent decline in the second quarter of 2008, a 13 percent decline in the third quarter and a 20.7 percent slide in the fourth quarter ó worrisome numbers considering that construction was responsible for 25 percent of all new jobs created between 1998 and 2007 and represented 13.9 percent of the total labor pool in 2007.
The worldwide financial crisis that began in September 2008 and developed into a full-blown global recession is further affecting the Spanish economy. First, the budget deficit of 2008 has been compounded by the governmentís efforts to spur economic activity through roughly 50 billion euro ($66 billion) in stimulus ó efforts that began before the global economic crisis, as they were meant to prevent the construction sectorís collapse after the housing bust.
With credit tightened and the housing contraction in full swing, Spainís government felt (and still feels) that it had no alternative but to try to spend its way out of unemployment problems; 8 billion euro has been distributed directly to local authorities for public works projects meant to create 200,000 jobs. Unlike the fiscally conservative and export-oriented Germany, which has thus far led an EU-wide rejection of major stimulus initiatives, Madrid understands that it will only exacerbate the crisis if it allows the construction sector, which is responsible for such a large portion of the total labor pool, to self-destruct.
The problem with spending, however, is that the Spanish public debt has ballooned (from 36.2 percent of GDP in 2007 to an estimated 55.6 percent of GDP in 2009) as the government attempts to assuage the effects of the crisis. This contributed to Standard & Poorís decision in January 2009 to downgrade Spainís sovereign debt rating from AAA. The downgrade will make Madridís efforts to raise further funds difficult, as it increases the price Spain will have to pay for debt on the international bond market ó as well as insurance on the risk of default. Since strict monetary policy rules set by the ECB prevent Spain from printing money like the United States or United Kingdom, Madrid depends on global demand for its debt to fund its stimulus packages. This presents a problem at a time when credit is flowing en masse toward the safety of U.S. Treasury bills.
The Recessionís Effects on Industrial Output
Spainís industrial production declined 22 percent in February (compared to February 2008), after a similarly dismal 20.9 percent decrease in January (compared to January 2008), according to a report released by the INE in early March. The sharpest fall recorded was in the automotive sector, where production declined by a whopping 47.6 percent in February as global demand for auto exports and industrial goods declined. Spainís automotive sector accounts for about 10 percent of the countryís total economic output and 15 percent of its total exports.
Thankfully for Spain, exports as a whole only account for roughly 27 percent of GDP, so industrial output numbers are not as concerning as they are for Sweden or Germany, countries that depend on exports for around 50 percent of GDP. But the overall slump in the construction and housing sectors is compounding the recessionís effects on unemployment. Spainís GDP is therefore forecast to contract by up to 5 percent, according to the more pessimistic forecasts; the IMF and the Spanish central bank thus far predict a more modest 3 percent GDP contraction. Meanwhile, the 2008 budget deficit is set to balloon to 8.3 percent of GDP in 2009 ó again, according to the moderate forecast of the Spanish central bank ó which is particularly troubling considering that EU regulations call for budget deficits to remain below 3 percent of GDP among eurozone members. (However, the European Union has allowed Spain to breach the 3 percent threshold until 2012.)
Deflation and the Looming Banking Problems
Completing the recipe for economic agony is the fact that Spain is the first European country to face possible deflationary pressures in the current recession. In late March, the INE reported that consumer prices fell 0.1 percent in March from a year ago, the first such drop since records began in 1961. Deflationary pressures in Spain, which historically is a high-inflation economy, are certain to rattle other European governments. While the year-on-year decline in consumer prices in March reflects a drop in commodity prices and is not necessarily representative of a coming deflationary spiral, rising unemployment and slumping demand for manufactured products certainly are not going to help instill confidence.
The trouble with deflationary spirals is that they are difficult to reverse, as they are in part a psychological phenomenon. As prices decline, consumers may begin to delay their purchases to the future, particularly if their confidence in the economy and the likelihood that they will keep their jobs is reduced. This may be compounded by a spike in unemployment, because people without jobs understandably tend to delay all but the most essential purchases. As consumption declines, companies have to stall production and lay off staff, creating a self-reinforcing loop. With Spanish unemployment projected to reach 20 percent in the next eight months, this scenario is becoming a clear possibility.
Spain as a Canary in the Coal Mine?
Fellow European governments will be watching Spain closely. Madridís problems are exacerbated by the countryís particularly severe housing correction, but are not wholly unique to Spain. First, the housing boom was certainly most egregious in Spain, but Europe as a whole is facing coming corrections; the Baltic states, United Kingdom and Ireland are in trouble similar to Spainís, and some form of correction is in store for Hungary, Bulgaria, Belgium, Slovenia, the Czech Republic, Greece, Croatia and Denmark.
Furthermore, in Europe as a whole, birthrates are low ó the EU birthrate is 1.5 births per woman, well below the ďreplacement rateĒ of 2.1 ó while life expectancy is high. This is creating a situation where the labor pool is shrinking while the retiree pool is growing. The Spanish birthrate is in fact even lower than the EU birthrate at 1.37 births per woman in 2006, with foreign women accounting for 16.5 percent of the total. As the tax burden to support the retiring population increases on laborers, demand for housing will stall and deflation in the housing market is very likely. Under deflationist market conditions, banks will have to tighten lending even further because property values will be declining and few financial institutions will willingly grant loans for assets they know will become less valuable over time. While this may be expected for car loans, mortgages have far longer terms, and the odds of the lender being stuck with a defaulted loan are greater. As banks respond to the risk of deflating asset values, the demand for houses will decline even further as first-time buyers and young families are squeezed out of the market.
In the near term, the coming recession will affect all European countries. The global demand slump is causing industrial output to be slashed across the continent, with rising unemployment and declining demand creating greater fears of a deflationary spiral. For Europe this is particularly problematic because industries and companies rely on banking for funding ó much more so than in the United States, where companies are more comfortable getting funding from the stock and security markets ó so any slowdown in the corporate sector will lead to one in the banking sector. This is a concern because the Europeans have not even begun resolving problems in their banking sectors, which are regulated independently by each EU member state ó and there is no consensus in sight on some form of EU-wide oversight.
Because of its early start on the economic recession, Spain is shaping up to be a canary in the coal mine for other European governments. Capitals around the continent will be watching how the Spanish economy reacts to the coming months ó particularly for signals from the international credit markets regarding the stability of the Spanish public debt, and for any potential rise in social and political unrest.